The Right Legal Structure For the
Small Business Owner
Salim Omar, CPA
No one entity is perfect for every business venture; there are varying
factors that would favor the selection of one entity over another. There
are several different legal structures under which you can choose to operate:
sole proprietorship, partnership, limited liability company (LLC), S-corporation,
C-corporation and non-profit corporation. Each has advantages and disadvantages.
In this article, I have given you an overlay of the pros and cons of two
of my favorite types of entities, S-Corporation and LLC.
S-CORPORATION
Many business owners hesitate to the double taxation rules imposed on
C-corporation. Setting up your business as an S-corporation alleviates
this “double taxation” rule. An S-corporation begins its existence
as a general corporation (C-corporation) upon filing the articles of incorporation
with the secretary of state. After the C-corporation has been formed,
it may elect “S-corporation status” by submitting IRS form
2553 to the Internal Revenue Service (in New Jersey, a state filing is
required as well).
Once a corporation makes the Subchapter S-election to be an S-corporation,
profits and losses are passed through the corporation and are reported
on the individual tax returns of the respective shareholders of the S-corporation.
This is the same basic “pass-through” treatment afforded partnerships
and LLCs. Thus, the key distinction of the S-corporation is that profits
and losses are not taxed at the corporate/business level like they would
be if the corporation remained as a C-corporation.
Your decision to be an S-corporation isn’t permanent. If you later
find there are tax advantages to being a regular corporation, you can
easily drop your S-corporation status. On the other hand, the opposite
may not be true due to hurdles like the built-in gains tax.
Advantages of S-corporations
There are several advantages of an S-corporation:
Receives limited liability protection accorded to corporations; avoids
the double-tax feature of taxation of your corporate profits; permits
benefit of offsetting business losses incurred by the corporation against
your income; interest you incur to buy S-corporation stock is potentially
deductible as an investment interest expense; upon selling your S-corporation,
your taxable gain on the sale of the business can be less than if you
operated the business as a regular corporation; self-Employment Tax Savings.
In an S-corporation, only earnings actually paid out to an owner as compensation
for services are subject to payroll taxes. Any money distributed to the
shareholder as a dividend is not subject to payroll taxes or to self-employment
tax.
Disadvantages of S-corporations
Corporate Formalities: An S-corporation follows the same state formalities
as a C-corporation (i.e., filing Articles of Incorporation and paying
state fees). In addition, an S-corporation must make a special tax election
under sub-chapter S of the Internal Revenue Code by filing IRS Form 2553.
Passive Investment Income and S-corporations: If a corporation claims
income from a passive investment (e.g., from real estate owned) for three
consecutive years, and if that income exceeds 25 percent of the corporation’s
gross receipts, S-corporation status may be terminated by the IRS. Most
real estate investors, for example, prefer placing real property in an
LLC (Limited Liability Company) rather than an S-corporation for this
very reason.
Lack of Flexibility: S-corporations offer less generous loss deductions
compared to LLCs. They also allow lesser classes of ownership (such as
voting and non-voting), have less freedom in deciding how profits and
losses are to be divided, and are limited to 75 shareholders and to the
S-corporation requirement that shareholders be U.S. citizens.
Minimum New Jersey Corporate Tax: New Jersey requires all S-corporations
to pay the minimum corporate tax of $500 regardless if the business reports
a loss. An LLC with two or less members is more advantageous in that no
New Jersey tax applies if it reports a loss.
LIMITED LIABILITY COMPANY (LLC)
An LLC is a business entity consisting of one or more “persons”
(meaning an individual, general partnership, association, trust, estate
or corporations) conducting business for any lawful purpose. This form
of business entity is a hybrid between a partnership and a corporation
in that it combines the “pass-through” treatment of a partnership
with the favorable limited liability accorded to corporate shareholders.
While an LLC has many of the same characteristics as an S-corporation
or a limited partnership, it is, in many cases, more flexible. For example,
it is possible to use an LLC to allocate profits differently from ownership
interests, or to get around the general partner’s personal liability
in a limited partnership. Every state, other than Hawaii and Vermont,
allows limited liability companies.
Advantages of LLC
Limited Liability to Members: With a few narrow exceptions, LLC members
are not subject to the debts and obligations of the LLC and thus enjoy
the same “limited liability” of a corporation. Like limited
partnerships and corporations, an LLC is recognized as a separate legal
entity from its “members.”
Flexibility: Should members of an LLC desire additional tax savings, it
can elect to change its tax status to that of a regular corporation. This
is not possible with S-corporations. LLCs offer more generous loss deductions
than S-corporations, allow more classes of ownership (such as voting and
non-voting), have more freedom in deciding how profits and losses are
to be divided, and are not limited to 75 shareholders nor to the S-corporation
requirement that shareholders be U.S. citizens.
Depending on your state’s laws, LLCs possibly are not bound by sometimes-troublesome
corporation rules such as “minimum capitalization.” In most
states, LLCs do not have to hold shareholders meetings, don’t have
to keep minutes, and don’t issue stock certificates.
Disadvantages of LLC
Transferability of Ownership: No one can become a member of an LLC (either
by transfer of an existing membership or the issuance of a new one) without
the consent of members having a majority in interest (excluding the person
acquiring the membership interest) unless the articles of organization
provide otherwise.
Duration: An LLC does not have a reliable continuity of existence. The
articles of organization must specify the date on which the LLC’s
existence will terminate. Unless otherwise provided in the articles of
organization or a written operating agreement, an LLC is dissolved at
the death, withdrawal, resignation, expulsion, or bankruptcy of a member
(unless within 90 days a majority in both the profits and capital interests
vote to continue the LLC).
Formalities: Filing to form an LLC can be extremely complicated, and the
paperwork needs to be completed meticulously. The existence of an LLC
begins upon the filing of the Articles of Organization with the Secretary
of State. The articles must be on the form prescribed by the Secretary
of State. Among the required information on the form is the latest date
at which the LLC is to dissolve and a statement as to whether the LLC
will be managed by one manager, more than one manager, or the members.
Operating Agreement Required: To validly complete the formation of the
LLC, members must enter into an Operating Agreement. This Operating Agreement
may come into existence either before or after the filing of the Articles
of Organization and may be either oral or in writing.
It is reasonably well-accepted and understood that selecting the most
appropriate entity is extremely important when you first get into business.
The fact not clearly understood by most small-business owners is its significance
when you are already in business.
For existing businesses, it is important to know that one type of entity
selection may be more advantageous in one year but not in another, due
to a shift in circumstances. I recommend that your accountant review the
appropriateness of your entity at least once annually. An accountant well-versed
in this area will provide excellent insight into which entity is right
for you.
Remember that choosing the right business structure can save you money
and the pain of many headaches!
This article speaks in general terms for ease of understanding, and does
not address many exceptions and details. It is not intended to be legal
or tax advice or to be used in substitution for consulting qualified legal
and tax advisors.
Salim Omar, CPA, is the leading tax authority for small businesses in
New Jersey. He is the author of the popular book titled, Straight Talk
About Small Business Success In New Jersey, now available in all Barnes
and Noble bookstores and on Amazon.com.
More free information can be accessed on his Web site : www.OmarGroupCPA.com
or by calling (732) 566-3660.
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